Understanding financial statements

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Understanding Financial Statements Sanjay Dhamija sdhamija@imi.edu sandha@hotmail.com Why Accounting  Informational requirement of a number of stakeholders in the business  Internal Stakeholder     External Stakeholders        Owners Management Employees Government/ Tax department Investors Banks/Lenders Suppliers/Creditors NGOs/ Industry associations Researchers Accounting is the tool for providing financial information to various stakeholders Financial Accounting Information  Predominately used by external stakeholders though managers also use it for decision making  To ensure that the accounting information is `true & fair’  Generally Accepted Accounting Principles (GAAP)  Accounting Standards  Unification of Accounting Standards (IFRS)  Accounting principles are not `exact’  Some latitude with the management GAAP  GAAP  Good accounting practices evolved by the profession over a period of time  Most of these practices have been adopted explicitly in the Accounting Standards  Accounting Standards  Mandatory accounting/ disclosure principles prescribed by an authority  In India Accounting Standards are prescribed by the Institute of Chartered Accountants of India  So far 32 accounting standards have been issued by the ICAI Please note  Financial Statement are prepared in accordance with the applicable GAAP/ Accounting Standards  The format is prescribed by the Companies Act 1956  They are audited by the `external auditors’  The audit report is addressed to the shareholders  In case of listed companies – periodic disclosure (quarterly basis) is required to be made  Annual accounts are required to be presented to the shareholders’ for approval within six months of the close of the year Basic Financial Statements  To answer the three basic questions  How much profit was generated by the business over a particular period?  What are the assets and liabilities of the business at the end of a particular period?  What were the sources and uses of cash over a particular period?  Financial Statements  Profit & Loss Account  Balance Sheet  Cash Flow Statement Income Statement Profit and Loss Account of XYZ Ltd for the Year ended March 31st 20XX Income Sales Other Income Expenditure Material and Other Expenditure Interest Depreciation Profit Before Tax Provision for Tax Profit After Tax Prior period adjustments Extra Ordinary Items Profit available for appropriations Appropriations Dividend Dividend Distribution Tax General Reserve Surplus carried to Balance Sheet Schedule No Previous Year Current Year xxx xxx xxx xxx xxx xxx xxx xxx xxx xxx xxx xxx xxx xxx Revenue Recognition  Revenue  Sales of Goods  Rendering of Services  Use by others of enterprise resources yielding interest, royalties and dividends  Sales of Goods  Seller has transferred property in goods to the buyer for a consideration  Transfer of significant risk and rewards of ownership to the buyer Revenue Recognition  Rendering of Services  Recognise revenue when services are performed  Proportionate Completion Method  Performance consists of a series of acts  Revenue recognised proportionately by reference to performance of each act  Completed Service Contract Method  Performance consists of a single act; or  Performance can’t be deemed to be completed unless fully executed Contingent Liabilities  Accounting treatment of a contingent loss    If it is likely that a contingency will result in a loss to the enterprise, then it is prudent to provide for that loss in the financial statements If there is conflicting or insufficient evidence for estimating the amount of a contingent loss, then disclosure is made of the existence and nature of the contingency Provisions for contingencies are not made in respect of general or unspecified business risks since they not relate to conditions or situations existing at the balance sheet date Contingent Liabilities  The following information should be provided in respect of contingent liability  the nature of the contingency  the uncertainties which may affect the future outcome  an estimate of the financial effect, or a statement that such an estimate cannot be made Contingent Liabilities Company Year ended Contingent Liability Net Worth CL as a % of NW SPIC 2004 126.48 2.15 5882 Hindustan Motors 2004 137.04 15.09 908 Essar Steel 2004 3108.64 589.01 528 Sakthi Sugars 2003 177.19 37.92 467 HCC 2004 833.97 238.74 349 Gammon India 2004 581.58 184.07 316 Ispat Industries 2004 2145.41 833.29 257 Esab India 2003 28.28 12.40 24 Skansha Cementation 2003 513.41 91.58 561 Cash Flow Statement Accounting Standard - Why Cash Flow Statement  To assess the ability of the business to generate cash and its utilization  P&L based upon accrual concept doesn’t reveal cash from operations  Other sources and uses of cash impact balance sheet  To have an overview of sources and uses of cash in the accounting period a Cash Flow Statement is prepared What is Cash  Cash comprises cash on hand and deposits with banks  Cash Equivalents  Short term, highly liquid investments  Readily convertible into cash  Insignificant risk of changes in value Cash Flow Statement  To be prepared and presented for each period for which financial statements are prepared  Cash flow should be classified into  Operating Activities  Investing Activities  Financing Activities  The sum of cash flow from these activities should explain change in cash balance over the accounting period Operating Activities  Principal revenue-generating activities  Generally result from the transactions and other events that enter into the determination of net profit or loss  Examples  Receipts from sale of goods or rendering of services  Payments to suppliers for goods and services  Payment to employees  Payment of income tax Investing Activities  Acquisition and disposal of long-term assets and other investments  For acquiring resources intended to generate future income and cash flow  Examples       Payment to acquire fixed assets Receipts from disposal of fixed assets Payments for acquiring investments Cash advances and loans made Recovery of cash advances and loans Receipt of dividend/ interest on investments Financing Activities  That result in changes in the size and composition of the owners’ capital and borrowings of the enterprises  Useful to predict claim on future cash flow by the providers of funds  Examples  Cash proceeds from issue of shares  Cash proceeds from issuing debentures and other long term borrowings  Cash repayments of amount borrowed  Payment of interest / dividend Extra-Ordinary Items  Cash flow from extra-ordinary items should be separately disclosed classified into operating, investing and financing activities Taxes on Income  Tax paid to be classified as cash flow from operating activities unless they can be specifically identified with financing and investing activities Non Cash Transactions  Investing and Financing Transactions that not require use of cash  Exclude from cash flow statement  Disclose separately elsewhere in the financial statements Cash From Operations  Direct Method  Major classes of receipts and payments for operating activities are considered  Indirect Method  Adjust Net profit or Loss  non-cash items  changes in current assets and liabilities  Items that can be classified as financing or investing cash flows Disclosure  Components of Cash and cash equivalents  Reconciliation of amounts in the Cash Flow Statement with the items reported in the Balance Sheet  Amount of significant cash and cash equivalents held by the enterprise that are not available for use by it [...]... Accounts must be maintained on an accrual basis and according to double entry book keeping system (section 209)  The Balance Sheet and the Profit & Loss account must be prepared for every financial year  The financial statements must be laid before the Annual General Meeting of the shareholders for approval within six months of the close of the year (Section 210)  The balance sheet of a company shall... activities  Not expected to recur frequently or regularly  Prior period items  Income or expenses which arise in the current period as a result of errors or omissions in the preparation of the financial statements of one or more prior periods Summary     Profit & Loss A/c is an account showing income and expenses Revenue/ Income is recognised when earned Expenses are recorded when incurred Basic... Liabilities & Provisions Net Current Assets 4 a) Miscellaneous Expenditure to the extent not written off or adjusted b) Profit & Loss Account TOTAL Figures as at the end of current financial year Figures as at the end of previous financial year Sources of Funds
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